Fundamentals of Corporate Finance Chapter Valuing Stocks Fifth Edition Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- Topics Covered Stocks and the Stock Market Book Values, Liquidation Values and Market Values Valuing Common Stocks Simplifying the Dividend Discount Model Growth Stocks and Income Stocks There are no free lunches on Wall Street Market Anomilies and Behavioral Finance McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- Stocks & Stock Market Primary Market - Place where the sale of new stock first occurs Initial Public Offering (IPO) - First offering of stock to the general public Seasoned Issue - Sale of new shares by a firm that has already been through an IPO McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- Stocks & Stock Market Common Stock - Ownership shares in a publicly held corporation Secondary Market - market in which already issued securities are traded by investors Dividend - Periodic cash distribution from the firm to the shareholders P/E Ratio - Price per share divided by earnings per share McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- Stocks & Stock Market Book Value - Net worth of the firm according to the balance sheet Liquidation Value - Net proceeds that would be realized by selling the firm’s assets and paying off its creditors Market Value Balance Sheet - Financial statement that uses market value of assets and liabilities McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- Valuing Common Stocks Expected Return - The percentage yield that an investor forecasts from a specific investment over a set period of time Sometimes called the holding period return (HPR) Div1 + P1 − P0 Expected Return = r = P0 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- Valuing Common Stocks The formula can be broken into two parts Dividend Yield + Capital Appreciation Div1 P1 − P0 Expected Return = r = + P0 P0 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- Valuing Common Stocks Dividend Discount Model - Computation of today’s stock price which states that share value equals the present value of all expected future dividends Div1 Div2 Div H + PH P0 = + + + H (1 + r ) (1 + r ) (1 + r ) H - Time horizon for your investment McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- Valuing Common Stocks Example Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively At the end of three years you anticipate selling your stock at a market price of $94.48 What is the price of the stock given a 12% expected return? McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 10 Valuing Common Stocks Example Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively At the end of three years you anticipate selling your stock at a market price of $94.48 What is the price of the stock given a 12% expected return? 3.00 3.24 350 + 94.48 PV = + + (1+.12) (1+.12) (1+.12) PV = $75.00 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 18 Valuing Common Stocks Example Our company forecasts to pay a $5.00 dividend next year, which represents 100% of its earnings This will provide investors with a 12% expected return Instead, we decide to plow back 40% of the earnings at the firm’s current return on equity of 20% What is the value of the stock before and after the plowback decision? McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 19 Valuing Common Stocks Example Our company forecasts to pay a $5.00 dividend next year, which represents 100% of its earnings This will provide investors with a 12% expected return Instead, we decide to blow back 40% of the earnings at the firm’s current return on equity of 20% What is the value of the stock before and after the plowback decision? No Growth P0 = = $41.67 12 McGraw-Hill/Irwin With Growth g =.20×.40 =.08 P0 = = $75.00 12 −.08 Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 20 Valuing Common Stocks Example - continued If the company did not plowback some earnings, the stock price would remain at $41.67 With the plowback, the price rose to $75.00 The difference between these two numbers (75.0041.67=33.33) is called the Present Value of Growth Opportunities (PVGO) McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 21 Valuing Common Stocks Present Value of Growth Opportunities (PVGO) - Net present value of a firm’s future investments Sustainable Growth Rate - Steady rate at which a firm can grow: plowback ratio X return on equity McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 22 No Free Lunches Technical Analysts Forecast stock prices based on the watching the fluctuations in historical prices (thus “wiggle watchers”) watchers McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 23 No Free Lunches Scatter Plot of NYSE Composite Index over two successive weeks Where’s the pattern? McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 24 Random Walk Theory The movement of stock prices from day to day DO NOT reflect any pattern Statistically speaking, the movement of stock prices is random (skewed positive over the long term) McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 25 Random Walk Theory Coin Toss Game Heads Heads $106.09 $103.00 Tails $100.43 $100.00 Heads Tails $97.50 Tails McGraw-Hill/Irwin $100.43 $95.06 Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 26 Random Walk Theory McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 27 Random Walk Theory McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 28 Random Walk Theory Market Index 1,300 1,200 1,100 Cycles disappear once identified McGraw-Hill/Irwin Last Month This Month Next Month Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 29 Another Tool Fundamental Analysts Research the value of stocks using NPV and other measurements of cash flow McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 30 Efficient Market Theory Weak Form Efficiency Market prices reflect all historical information Semi-Strong Form Efficiency Market prices reflect all publicly available information Strong Form Efficiency Market prices reflect all information, both public and private McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 31 Efficient Market Theory Announcement Date McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 6- 32 Behavioral Finance Attitudes towards risk Beliefs about probabilities McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved [...]... movement of stock prices is random (skewed positive over the long term) McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 25 Random Walk Theory Coin Toss Game Heads Heads $ 106. 09 $103.00 Tails $100.43 $100.00 Heads Tails $97.50 Tails McGraw- Hill/Irwin $100.43 $95 .06 Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 26 Random Walk Theory McGraw- Hill/Irwin... Present Value of Growth Opportunities (PVGO) McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 21 Valuing Common Stocks Present Value of Growth Opportunities (PVGO) - Net present value of a firm’s future investments Sustainable Growth Rate - Steady rate at which a firm can grow: plowback ratio X return on equity McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill... information, both public and private McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 31 Efficient Market Theory Announcement Date McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 32 Behavioral Finance Attitudes towards risk Beliefs about probabilities McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All... equity of 20% What is the value of the stock before and after the plowback decision? McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 19 Valuing Common Stocks Example Our company forecasts to pay a $5.00 dividend next year, which represents 100% of its earnings This will provide investors with a 12% expected return Instead, we decide to blow back 40% of the... prices (thus “wiggle watchers”) watchers McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 23 No Free Lunches Scatter Plot of NYSE Composite Index over two successive weeks Where’s the pattern? McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 24 Random Walk Theory The movement of stock prices from day to day DO NOT... percentage of earnings plowed back into operations g = return on equity X plowback ratio McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 18 Valuing Common Stocks Example Our company forecasts to pay a $5.00 dividend next year, which represents 100% of its earnings This will provide investors with a 12% expected return Instead, we decide to plow back 40% of the... Constant Growth DDM - A version of the dividend growth model in which dividends grow at a constant rate (Gordon Growth Model) Div1 P0 = r−g Given any combination of variables in the equation, you can solve for the unknown variable McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 14 Valuing Common Stocks Example What is the value of a stock that expects to pay... McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 27 Random Walk Theory McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 28 Random Walk Theory Market Index 1,300 1,200 1,100 Cycles disappear once identified McGraw- Hill/Irwin Last Month This Month Next Month Copyright © 2007 by The McGraw- Hill Companies, Inc All rights... Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 16 Valuing Common Stocks If a firm elects to pay a lower dividend, and reinvest the funds, the stock price may increase because future dividends may be higher Payout Ratio - Fraction of earnings paid out as dividends Plowback Ratio - Fraction of earnings retained by the firm McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies,... expected return Instead, we decide to blow back 40% of the earnings at the firm’s current return on equity of 20% What is the value of the stock before and after the plowback decision? No Growth 5 P0 = = $41.67 12 McGraw- Hill/Irwin With Growth g =.20×.40 =.08 3 P0 = = $75.00 12 −.08 Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 6- 20 Valuing Common Stocks Example - continued If the